The Mating Habits of Options Exchanges

THE SUCCESS OF THE INTERNATIONAL SECURITIES EXCHANGE, which has agreed to be acquired by Deutsche Bourse, is predicated on asking a simple question: If we build it, will they come?

The logic of this question, so often misunderstood by ISE's competitors, helped
ISE
become a top U.S. options exchange. Now, the deceptively simple question emerges yet again as ISE has accepted a $2.8 billion cash-takeover offer from the German exchange, and the challenge of creating a transatlantic derivatives market.

For investors interested in capitalizing on this deal, the best way to speculate on options and futures exchange mergers may be to buy calls on the
IntercontinentalExchange
or
Nymex Holdings.

These futures exchanges remain glaringly absent from the exchange consolidation wave that is now reshaping the business, and both are increasingly mentioned as takeover targets.

For now, ISE, which had been expected to remain independent, faces significant challenges building a truly international derivatives exchange. This is not an insignificant challenge either, even though it is attracting far less attention from investors than the staggering premium ISE received from Deutsche Bourse.

When building ISE, and also when expanding its operations, ISE's co-founders, David Krell and Gary Katz, took the then unprecedented step of asking brokerage firms what they wanted in an options exchange, and then they built it, and investors came. Competitors did almost the opposite.

Messrs. Krell and Katz asked that simple question at a time when competing exchanges behaved like monopolists that were more concerned with taking care of member-owners, which included hordes of "floor traders," than with truly addressing the needs of investors. The ISE approach may seem obvious, but in fact it is not, and it is still a revolutionary approach in the exchange sector.

When Eurex, which is Deutsche Bourse's derivatives unit, failed to successfully create a U.S. futures exchange, many derivatives-industry executives spoke of the German exchange's arrogance in thinking they could build a business solely by creating an exchange that was arguably more efficient than competing U.S. futures exchanges.

Eurex failed because it did not really speak to customers, and therein learned the hard lesson that logic alone is not enough to guarantee success in the U.S. exchange sector.

Increasingly, success in the U.S. derivatives market is predicated on talking to potential customers and creating and maintaining a scalable foundation of trading technology that can be leveraged by firms that provide liquidity and order-flow.

In essence, this is what ISE offers Deutsche Bourse, as well as a presence in the world's largest capital market.

In return, aside from an all-cash, riskless offer, ISE receives a much larger foundation upon which to apply its operational discipline, and further test itself.

During a conference call this morning with investors, Eurex, which is the Deutsche Bourse unit that will own ISE should the deal be approved by U.S. regulators and shareholders, said that it has 400 members. ISE has 150 members.

The exchanges also will have a broad product portfolio of equity derivatives, index derivatives and long-term interest rate derivatives, denominated in U.S. dollars and euros. There is minimal overlap between the two constituencies, which creates opportunities to try to cross-sell products.

"I'm excited about what we can do with a much larger trading base and member base," said ISE's Katz, who succeeds Krell as chief executive in January 2008. "There are many opportunities."

Those opportunities are the wild card in this transaction for it is a largely untested assertion -- at least in any non-anecdotal way -- that there is sustainable demand for transatlantic derivatives trading.

Heiko Frantzen, an analyst at Sal Oppenheim in Frankfurt, said he does not think many Germans are interested in buying U.S. products, but he said perhaps U.S. investors might be interested in German products.

Yet, he cautions against initially expecting too much from cross-border selling. He said that is a second-phase issue. The first phase, he said, is for Deutsche Bourse to establish international operations at a time when its primary European competitor, Euronext, has recently merged with the New York Stock Exchange.

"The problem for Deutsche Bourse is that setting up something by themselves is not possible; they have to buy. It's time for them to gain entry into the U.S. market, otherwise they never will," said Frantzen, alluding to the near-daily speculation of options exchange takeovers that sweep through the U.S.

To be sure, ISE negotiated a good deal for itself. The offer is all-cash, and removes all the risk, at least for ISE, in asking the old question that helped build its business.

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